Section of Taxation
The Tax Lawyer vol. 52 no. 2 Winter 1999


The Tax Lawyer
VOL. 52 NO. 2

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Article Absracts

David P. Hariton


This article is written in response to Judge McKee’s dissent from the Third Circuit affirmence of the Tax Court’s decision for the Commissioner ACM v. Commissioner. "I can’t help bus suspect, " Judge McKee said, That the majority’s conclusion to the contrary is, in its essence, something akin to a "small test." If the scheme in question smells bad, the intent to avoid taxes defines the result as we do not want the taxpayer to "put one over." … The fact that ACM may have "put one over" in crafting these transactions ought not to influence our inquiry. Our inquiry is cerebral, not visceral. To the extent that the Commissioner is offended by these transactions he should address Congress and or the rulemaking process, and not the courts.

I disagree, and I endeavor below to shed light on both the proper role and the proper operation of the economic substance doctrine. My analysis is based on the language of relevant decisions that have been handed down over the past sixty-five years. In brief, the conclusions I reach are as follows:

First, the economic substance doctrine is not just a small test, because it only applies to transactions which lack economic substance. The doctrine permits taxpayers to retain even the most egregious tax benefits if they arise from transactions with meaningful economic consequences. Colgate would not have lost under the economic substance doctrine if, for example, it had purchased an office building, rather than an AA- rated note, and sold it the following year for cash plus contingent payments (unless the sales price had been locked in).

Second, tax benefits will not be disallowed merely because they arise from transactions which lack economic substance, Rather, if the transactions lack economic substance, then the court may overturn the formalistic results. The court may still decide, however, that the formalistic results are not disturbing enough to be overturned. After all, form, not substance, determines tax liabilities under a realization-based income tax.

Third, economic substance is not about profit potential. Any transactions with significant net equity will produce a significant profit. A transaction only has economic substance, however, if it alters the taxpayer’s economic position in a meaningful way (apart from its tax consequences). A complicated way of investing cash lacks economic substance- even though it obviously produces profit- if it leaves the taxpayer in substantially the same position as if the cash had been left in the bank. Taking a naked position in commodities has economic substance, however, even if it is likely to produce a loss. Economic substance must be judged in relation, however, to the size of relevant tax benefits.

Finally, a more complex, tax-advantaged way of executing a transaction should not lack economic substance if the transaction itself has economic substance. A court must distinguish, however, between real and merely purported relationships in this regard. For example, there was no meaningful economic difference between using several "mirror" subsidiaries and using just one subsidiary to acquire a target corporation in the 1980s. The mirror subsidiaries were a way of effecting an acquisition, however, in the sense that if they were eliminated, what remained would not have been a more direct acquisition, but rather no acquisition at all. By contrast, Colgate argued that its contingent installment sale ("CINSI") transaction was merely a tax-advantaged way of repurchasing outstanding Colgate debt. If one eliminated the CINS transaction, however, the subsequent repurchase of Colgate debt would not have been affected (and conversely, after the CINS transaction was completed, the outstanding Colgate debt still had to be repurchased). Moreover, the relevant tax benefit (a large capital loss) bore no relation to the repurchase of outstanding debt. In fact, the CINS transaction was just a complex way of investing cash which lacked economic substance.


Keith E. Engel


Countries have long expressed an interest in preventing the tax-free outflow of capital beyond their borders. Taxpayers with appreciated assets are of particular concern, especially when they shift their assets offshore in order to recognize gains outside their home country’s jurisdictional reach. The United States, which views itself as a net exporter, is no exception. The United States has enacted several regimes to prevent these tax-free outflows, including a regime that taxes exiting assets at point of departure.

In their zeal to prevent outflows, many countries like the United States have overlooked the taxation of assets entering ( i.e. imported into) its taxing jurisdiction. The issue of entry, however, is no small matter. While the United States may view itself as a net exporter, the United States has consistently received substantial gross imports in terms of foreign trade and investment. Moreover, asset entry into the United States does not simply occur through traditional trade and investment but also through immigration when new arrivals become U.S. residents.

Taxation of entering assets presents differing concerns that taxation of exiting assets. With respect to exiting assets, the country at issue is largely concerned about losing jurisdictional control once those assets move beyond the border. Asset entry instead raises the question of whether the country at issue is asserting too much jurisdictional authority. In other words, should the country at issue tax entering assets in full even if much of the gain previously accrued offshore? Similarly, should the country at issue fully account for pre-entry accrued loss? Countries are divided in this regard.

The United States represents the majority view, treating the entry of assets as a nonevent when standing by itself. Assets entering countries with this view retain their historic basis to the extent the entering transaction would qualify as a nonevent if that transaction were to arise within a wholly domestic setting. This historic approach means that gain or loss of the post-entry sale of an asset is fully taken into account, regardless of whether that gain or loss economically accrued onshore or offshore.

A small minority of countries, including Canada, take the opposite approach. This latter approach treats entry as a deemed sale/repurchase regardless of how the entering transaction would otherwise be characterized in a wholly domestic setting. This deemed sale/repurchase creates a fair market value basis upon entry, thereby limiting the new country’s taxing jurisdiction to amounts that economically account solely after arrival.

The purpose of this article is to discuss the shortcomings of the current U.S. entry system and to provide alternative suggestions for reform, focusing mainly on the fair market value construct provided by the Canadian tax system. Part I of this Article describes the three basic forms in which assets enter the United States and how each form creates potential tax consequences that deviate from the underlying economics. Part II of this Article describes how Canada addresses these same forms of entry and how their system eliminates this potential for deviation to the extent their system adheres to a fair market value construct.

Part IV of this Article explores the historic justification of the current U.S. entry system. This examination reveals that the U.S. entry system may be legally defensible but that the system stems more from historical accident than from comprehensive forethought. This examination also reveals that the current U.S. entry system is administratively problematic, effectively favoring well-informed taxpayers at the expense of the U.S. fisc and the unwary. Part V of this Article then closes by describing possible solutions to the current U.S. entry system focusing primarily on a mark to market entry regime similar to that used by Canada.


Clayton S. Reynolds


According to the National Rural Electric Cooperative Association, rural electric cooperatives ("electric cooperatives") have a growth rate at the present time that is nearly three times that of investor-owned utilities; serve approximately eleven percent of the nation’s population; account for close to eight percent of the kilowatt hours sold in the United States; and own and maintain nearly half the electrical distribution lines in the country (covering three-quarters of the nation’s land mass). It is therefore not surprising, given the magnitude of the electric cooperative market, that the ongoing deregulation of the electric industry is raising novel tax issues for many electric cooperatives. This Article explores some of those issues.

To date, fourteen states have enacted electric restructuring legislation (Arizona, California, Connecticut, Illinois, Maine, Massachusetts, Montana, Nevada, New Hampshire, Oklahoma, Pennsylvania, Rhode Island, Virginia, and West Virginia); the public utility commissions of six states have issued comprehensive restructuring orders (Arizona, Maryland, Michigan, New Jersey, New York, and Vermont); and twenty-six states are actively studying restructuring proposals (either at the legislative or regulatory level). Most of the legislative and regulatory proposals currently being debated throughout the country relating to the deregulation of the electric industry recognize the need to permit the recovery (or, at least, partial recovery) of "stranded costs," as defined below. To allow open competition without providing for a utility’s recovery of costs, which it prudently incurred in the past, is generally thought to violate the regulatory compact existing between the utility and its regulatory body (and pursuant to which the utility was induced to make investments in its generating units).

The quantification of a utility’s stranded cost varies from proposal to proposal. Typically, however, a utility’s stranded cost is defined as the excess, or some percentage of the excess, of the utility’s book value of its generation related assets as determined for regulatory ratemaking purposes (which will almost certainly differ from its basis in these assets as determined for Federal income tax purposes) over the fair market value of these assets.

In order to permit the recovery of stranded costs, virtually all of the legislative and regulatory proposals provide for the payment of "non-bypassable charges" by the ultimate consumers of the electricity. Hence, regardless of the utility form which a consumer purchases its electricity, the consumer will be required to an additional charge that will be remitted to the utility that previously supplied the consumer with power, or more precisely, will be remitted to the utility having the historic service territory that included the consumer. Thus, a consumer cannot avoid (or "bypass") the charge by changing its supplier of electricity. This non-bypassable charge may consist of a one-time payment or, more typically, a continuing usage-based charge over a set number of years (typically, fewer than ten).

In the case of most investor owned utilities, the recovery of stranded costs by means of a non-bypassable charge is relatively straightforward. The utility collecting the charge is typically also the utility that incurred the stranded costs. However, most electric cooperatives (unlike most investor owned utilities) do not both generate and distribute electricity. Instead, a typical electric cooperative has either generation and transmission facilities ("G&T cooperatives") or distribution facilities ("distribution cooperatives") but not both.

A distribution cooperative typically purchases power from the G&T cooperative of which it is a member (pursuant to long-term "all-requirements" wholesale power contract). Since a distribution cooperative does not own any generating assets, it will normally have no stranded costs. The assets of a G&T cooperative, on the other hand, consist of generating and transmission assets and, therefore, a G&T cooperative will typically have stranded costs. However, since a G&T cooperative does not have a distribution system, it has no retail customers to whom it can pass a non-bypassable charge.

Thus, in the paradigm cooperative model, there is a manifest disconnect relating to the recovery of stranded costs. The entity which has the wherewithal to collect the non-bypassable charge (the distribution cooperative) has little or no stranded costs; the entity with the stranded costs, on the other hand, lacks the wherewithal to collect the non-bypassable charge. Therefore, in order to permit a G&T cooperative to recover its stranded costs, any legislative or regulatory solution must permit a downstreaming of a G&T cooperative’s stranded costs to its member distribution cooperatives (such that the stranded cost of the G&T cooperatives can be collected by the distribution cooperative members of the G&T cooperatives).

Assuming that applicable legislation permits such a downstreaming, a variety of tax issues are raised by the distribution cooperative’s collection of the non-bypassable charge and its remission of the charge to the G&T cooperative of which it is (or was) a member. In broad, these issues relate to questions of timing, characterization and consistency, These issues exist for tax-exempt G&T cooperatives, as well as for exempt distribution cooperatives. (All or virtually all distribution cooperatives are tax-exempt under section 501©(12) of the Internal Revenue Code of 1986, as amended (the "Code"); G&T cooperatives on the other hand may be either taxable or tax-exempt.) The complexity of the issues is greatest, however, in the case of a taxable G&T cooperative, and the focus of the Article is therefore limited to this type of cooperative.

Part II of this Article describes the special rules that apply taxable electric cooperatives and that give rise to many of the issues addressed in the remainder of this Article- that is, the ability of such cooperatives to deduct the patronage-sourced profits (or margins) which they allocate to their members. Part III of the Article uses a series of tables to demonstrate how tax consequences to a taxable G&T cooperative may depend not only on the timing but also the character (as patronage or non-patronage) of both the non-bypassable charge and the recovery (vis depreciation) of the associated stranded costs, and concludes that a mismatch in timing. Finally, Part IV turns to the precedents that bear upon the characterization of non-bypassable charges and the related recovery of cooperative’s stranded costs (as patronage or non-patronage), and argues that non-bypassable charges are best characterized as patronage-sourced income (and, in all events, should be characterized as such and if and to the extent the associated depreciation of the stranded costs has previously been treated as a patronage sourced deduction expense).